March 21, 2012

Speculation and Oil Prices

March 21, 2012

“Blaming speculators for rising oil prices is like blaming thermometers for a heat wave.”

Understandably anxious to show the American voters that he is “doing something” about high gas prices, President Obama lately has played the time-honored card of blaming shadowy speculators for our economic woes. Obama has gone so far as to call last year’s task force on oil speculation back into action.

Blaming speculators for rising oil prices is like blaming thermometers for a heat wave. If speculators correctly predict future movements in market prices, they personally profit but at the same time they smooth out price adjustments, effectively notifying everyone else aware of the impending change in the fundamentals.

We should never forget that speculators can make money anticipating price movements up or down. As both theory and history attest, when the federal government makes policy announcements that promise an increase in domestic oil production, then the world price of oil drops immediately in response.

Obama Calls Up the Task Force—Again

As this Miami-Herald story explains, Obama’s task force didn’t find anything last year. And in fact, Jay Carney inadvertently admits that the current call is a fishing expedition:

Pressed…for details on how an active working group would be reconstituted, [White House spokesman Jay] Carney said simply that rising prices are a worry now.

“What we are seeing now in the last several weeks and months is a new surge in the price of oil for a variety of reasons that have to do with the global oil market,” he said. “We are seeing then the concurrent spike in the price of gasoline that Americans pay at the pump, and the president believes that it’s important to be sure that there’s no fraudulent speculation involved in that – in those spikes in the price.”

As to why a working group should be restarted if it didn’t find anything last year and went dormant, Carney said that “you don’t know until you investigate what you might find. And whatever they found or didn’t find a year ago is not dispositive towards what they might find or might not find as they investigate going forward.” [Bold added.]

From their own statements, it should be clear that we are not putting words into Obama or Carney’s mouths: They know Americans are upset over high gasoline prices, so the Administration is sic’ing the Justice Department on the financial markets hoping to find something naughty going on. Generally speaking, this isn’t a responsible way to govern and ensure that markets develop without fear of political interference.

Why Successful Speculation Is Socially Useful

Last year, when the Commodities Futures Trading Commission (CFTC) filed lawsuits against specific oil traders, we commented on the details of the case. Today, here is a more general overview of the issues:

Speculators in financial markets act on the motto, “Buy low, sell high.” (It also works in reverse, where they can short-sell high, and cover low.) If they guess correctly then they reap a profit, but indirectly they also move prices toward their correct long-run values.

For example, suppose oil is currently trading at $85 per barrel, but that insiders think the situation in the Middle East is much closer to outright war than most people realize. These players then have a financial incentive to buy oil futures contracts, thereby pushing up the “futures price” of oil. Through the interconnection of various markets, this will push up the current (spot) price of oil too. The higher price of oil will lead producers with excess capacity to ramp up production now, and will lead oil consumers to economize more carefully in their usage.

Note that this is exactly what we want to happen: All of a sudden, if there is a greater probability that oil exports from the Middle East will be disrupted, then the “correct” response from the rest of the world is to (a) ramp up production and (b) slow down current consumption in order to (c) accumulate inventories in anticipation of the possible disruption. As in other arenas, so too in the financial and commodities markets, the Invisible Hand harnesses the profit motive to guide producers and consumers into making socially beneficial decisions.

What to Do About Rising Gas Prices?

If speculation is profitable, it moves prices toward their long-term levels. This is why blaming speculators for high gas prices is akin to blaming thermometers for a heat wave.

There’s nothing magical about this; it doesn’t rely on time machines taking oil from the future into the present. No, what happens is simple economics in action: Some oil producers currently have excess capacity, meaning they are physically capable of extracting more barrels per day, but they choose not to. The reason is that they reckon it will be more profitable for them to leave those potential barrels of crude in the ground, in order to sell them down the road at a higher price than what they could fetch today.

Now what happens to this equilibrium position if suddenly the U.S. government announces policies that will lead to a drastic increase in U.S. crude production in (say) five years? It means that the experts’ projections about future world crude prices now must be revised downward, relative to their original estimates. In light of the new information, oil producers who currently have excess capacity will decide it is now more profitable to extract their reserves at a more rapid rate, since the prospect of sitting on those barrels for another five years has suddenly become less appealing.

This is the straightforward mechanism by which announcements regarding future oil output can have an immediate effect today. To repeat, this isn’t merely some abstract blackboard discussion. When President Bush made a surprise policy announcement, oil prices fell $9 almost immediately.

Conclusion

The Obama Administration desperately wants to show the American voters that it is “doing something” about gas prices, and so predictably rolls out a fishing expedition for speculative skullduggery, even though the same task force came up with nothing last time. In both theory and practice, we know that speculators can be harnessed to push down oil prices. All it takes is a change in government policy that is more favorable to the domestic production of American energy sources.